US Agency Mortgage- Backed Securities (MBS)
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Research US Agency mortgage- backed securities (MBS) A foreign investor’s perspective November 2019 | ftserussell.com Table of contents Exec summary 3 US MBS market 3 What differentiates MBS from other fixed-income securities? 6 Possible benefits from investing in MBS 8 US Agency MBS ownership: domestic versus foreign investors 16 Challenges for foreign investors 18 Conclusion 22 Appendix 23 References 24 Sources 24 ftserussell.com 2 Exec summary The objective of this paper is to explore the US mortgage-backed securities (MBS) market from the perspective of a foreign investor. We pay particular attention to the US Agency MBS segment, owing to its size, liquidity, return and risk characteristics. First, we focus on the key defining feature of MBS, prepayment optionality, and what it means for investors. Second, we review other important characteristics of US Agency MBS, including their performance versus other asset classes, and the role MBS can play in the construction of fixed-income and multi-asset portfolios. Third, we examine the ownership structure of US Agency MBS to assess the role of foreign investors in this market, its evolution and current trends. Finally, we seek to explain why foreign investors hold a relatively small share of US Agency MBS market (15%) compared to domestic investors. US MBS market Introduction and overview Generally speaking, a mortgage is a loan made to a household or firm to finance the purchase of a home, land or any other real estate, and conceptually has existed for centuries. The process of transforming these individual loans into marketable securities is called securitization (also viewed by market participants as a form of transformation of illiquid assets into liquid securities) and involves a number of institutions. For example, Bank A originates mortgage loans to borrowers, including underwriting, funding and servicing. These US residential mortgages are then bought by Freddie Mac (Agency), which bundles them into a pool and sells them to a “bankruptcy-remote” special-purpose vehicle (SPV). The SPV issues MBS backed by this pool of loans and sells them to pension funds, asset managers and other investors. A mortgage-backed security is an instrument that represents an ownership in a pool of mortgages and, more importantly, where cashflows depend on the underlying pool of mortgages. Despite the first US MBS only being issued in 1968, the MBS market has grown to become the second largest segment of the US fixed income market after US Treasuries, with a total outstanding volume of $9.8 trillion as of March 2019 and a total issuance of $1.9 trillion in 2018 (Figures 1 & 2). Looking at historical numbers, recent issuance is below the peak seen in the early 2000s, while outstanding volumes continue to rise (Figure 3). ftserussell.com 3 Figure 1. Outstanding US bond market debt, $bn Figure 2. 2018 Issuance in the US bond market, $bn 9,881 1,906 Treasury Treasury 9,467 Mortgage Related 1,331 Mortgage Related Corporate Debt Corporate Debt Municipal Municipal 15,922 2,685 346 Other Other 3,810 4,604 1,166 Source: SIFMA. Data as of June 2019. Source: SIFMA. Data as of December 2018. Figure 3. US MBS historical outstanding volume and issuance, $bn 12,000 4,000 3,500 10,000 3,000 8,000 Issuance 2,500 6,000 2,000 1,500 4,000 Outstanding Outstanding Volume 1,000 2,000 500 0 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Outstanding Volume Issuance Source: SIFMA. Data as of December 2018. Main types of US MBS The majority of outstanding US mortgage-backed securities are Agency MBS (around 75%). These are guaranteed by the US government, either explicitly, issued by Ginnie Mae, or implicitly, issued by Government Sponsored Enterprises (GSE), like Fannie Mae and Freddie Mac. Therefore, Agency MBS are viewed as credit-risk free1 by market participants (as long as Fannie Mae and Freddie Mac stay under conservatorship). The most common Agency MBS structure is a pass-through, where investors are entitled to a pro-rata share of the cash flows from the underlying mortgages. Monthly interest and principal payments are then passed through from a pool of loans to security holders. 1In 2008 both Fannie Mae and Freddie Mac were placed into conservatorship with the Federal Housing Finance Agency (FHFA) in response to their deteriorated financial condition caused by the financial crisis. In January 2019, the regulator announced its plans to take Fannie Mae and Freddie Mac out of conservatorship. This will mean the introduction of risk-based capital requirements and revision of minimum leverage capital requirements for GSEs, which have been suspended since 2008. Implications for market participants will become clearer once the details are published. ftserussell.com 4 The rest of the Agency MBS market is made up of collateralized mortgage obligations (CMOs) – around 11% – that are issued against specific mortgage collateral and are divided into several bond classes, called tranches. This structure creates securities with a number of specific payment and maturity profiles, catering to different investor needs. Non-Agency MBS, also referred to as private-label MBS, are issued by institutions that have lower credit-worthiness relative to government agencies, or GSE, and typically do not meet the loan size limits or underwriting standards required. Therefore, they offer a higher yield to investors to compensate for the higher level of risk. The Non-Agency MBS market, represented by commercial and residential MBS, is significantly smaller (about 14% of US MBS), and less liquid compared to Agency MBS (Figure 4). Figure 4. US MBS market breakdown by outstanding volume Agency CMO CMBS 11% 6% Non-Agency Agency MBS 14% 75% RMBS 8% Source: SIFMA. Data as of June 2019. US MBS in fixed-income benchmarks It is worth noting that mortgage-backed securities also comprise a significant part of US and global fixed-income benchmarks. Looking at the FTSE US Broad Investment-Grade Bond Index (USBIG®) breakdown as of June 2019, the collateralized sector makes up 26.5% (Figure 5). Furthermore, the collateralized sector has a weighting of 16.4% (Figure 6) in the FTSE World Broad Investment-Grade Bond Index (WorldBIG®). Figure 5. FTSE USBIG Figure 6. FTSE WorldBIG 2.3% 26.5% 5.2% Treasury Government 58.8% Govt Govt Sponsored 16.4% Sponsored Collateralized Collateralized 40.3% 30.9% Credit Corporate 19.6% Source: FTSE Russell. Data as of June 2019. Source: FTSE Russell. Data as of June 2019. ftserussell.com 5 What differentiates MBS from other fixed-income securities? While being a key element of the fixed-income universe, mortgage-backed securities have a number of distinguishing characteristics, which we will investigate in more detail: • Prepayments • Negative convexity • Pay-offs frequency Prepayment optionality The prepayment option is the main feature of MBS, which differentiates it from other types of fixed-income securities. MBS cashflows are not known with certainty as homeowners can fully or partially prepay their mortgages prior to maturity. This feature makes MBS more complex and challenging compared to traditional non-callable bonds or even standard callable corporate bonds. What drives prepayments? Mortgage prepayments are mainly caused by either home sales, which happen due to life changing events of homeowners, or refinancing, which generally occur when mortgagors wish to take advantage of lower rates or access the increased equity in the house. A smaller proportion of prepayments is driven by defaults, curtailments and full payoffs. Defaults occur when borrowers stop making payments on their mortgage obligations. As for curtailments and full payoffs, the former happens when homeowners pay more than scheduled monthly to build up equity faster, while the latter means they pay their mortgages off completely (this typically happens if loans have a small remaining balance)2. What does the prepayment option (or call option) mean for investors? For the majority of MBS securities, it is an extra risk dependent on interest rates shifts. Therefore, they have a more pronounced duration uncertainty as illustrated below: Figure 7. How interest rates impact MBS duration Falling Rates Scenario Rising Rates Scenario Interest Interest Prepayment Duration Prepayment Duration Rates Rates Source: FTSE Russell. 2 “Anatomy of Prepayments”, Hayre, Young, Teytel and Cheng (2004). ftserussell.com 6 When interest rates fall, homeowners with fixed-rate mortgages are incentivized to refinance their loans at lower rates. This leads to an increase of principal prepayments and shorter duration (known as “contraction risk”). In this situation, MBS investors are paid off earlier than scheduled and face reinvestment at a lower interest rate. On the other hand, rising interest rates slow down principal prepayments, as homeowners are already locked into a more preferable mortgage rate. This increases duration for the MBS investors (known as “extension risk”), who are unable to reinvest at a higher rate. Negative convexity Prepayment risk translates into a negative convexity feature. Conventional straight bonds, which are non-callable, have known interest and principal repayment dates, and positive convexity (duration sensitivity to interest rate changes). This means that a price increase, when interest rates decline, is greater than a price decrease, when interest rates rise by the same amount. However, it is not the case for MBS. Rising prepayments dampen price appreciation in a declining interest rate scenario and may result in an underperformance versus a non-callable fixed-income instrument, such as a comparable US Treasury (due to negative convexity). The prepayment option introduces additional risk and adds complexity into the MBS analysis, as it requires both interest- rate and prepayment modelling. However, investors are compensated for taking on that extra risk. Diep, Eisfeldt & Richardson (2017) found in their study that MBS investments earn premia with respect to the prepayment risk factor3.